ECB hikes rates 25 bps in exit from crisis policy

Frankfurt: The European Central Bank raised interest rates by 25 basis points to 1.25% on Thursday, announcing its first hike since July 2008 to counter firming inflation pressures in the 17-country euro zone.

The euro was steady after the decision, which ECB policymakers had flagged heavily in advance. All but four of 80 economists polled by Reuters last week expected a 25 basis point rise.

The increase in the ECB’s benchmark refinancing rate marks a gentle exit from the central bank’s policy response to the global financial crisis. It had held the refi rate at a record low 1.0% since May 2009.

The ECB also raised its deposit rate by 25 basis points to 0.50%, and increased its marginal lending rate by the same amount to 2.0%.

“A - no surprise. B - the euro zone economy is strong enough to stand it, and C - it will be a little problem for the euro zone periphery but as long as the Eurosystem continues generous emergency assistance for stricken banks in the periphery, the periphery can bear it,” said Berenberg Bank economist Holger Schmieding.

The rate decision came less than 24 hours after Portugal announced it was seeking European Union support, a decision long expected by financial markets.

Lisbon’s announcement had not changed market expectations for a rise in rates, but ECB President Jean-Claude Trichet’s news conference at 6.00 pm will be eyed for signs markets are still justified in expecting more than one further rate hike this year.

For months the central bank has been privately pushing Lisbon to accept assistance, and the fact it has finally happened may free the ECB to take a firmer line on the budding inflationary risk.

The ECB is concerned that firm oil prices - near 2-1/2 year highs - could boost inflation expectations and financial markets are pricing in two further quarter-point rises in interest rates this year to follow a move on Thursday.

But the Frankfurt-based bank must be careful not to hurt the euro zone’s struggling economies by jacking up rates fast and Trichet, who shocked markets last month by signalling an April hike, may not want to heighten expectations for further rises.

“I think it is the start of a series but I think Trichet ... will try to temper any market expectations, which are already priced in, of further hikes to come,” said Lloyds interest rate strategist Eric Wand.

Bank-to-bank lending rates have already risen on rate hike expectations. The three-month Euribor rate has risen over 25 basis points since the start of the year and hit its the highest level since June 2009 on Thursday.

With Greece, Ireland and Portugal all being forced to rely on international bailouts and struggling to generate growth, the rate hike will carry risks. But the central bank believes it can tighten policy slowly enough to avoid doing serious damage.

It feels re-establishing its inflation-fighting credibility is more important to avert an upward spiral of prices and wages. Euro zone inflation rose to 2.6% last month, above the ECB’s medium-term target of just below 2.0%.

Tempering expectations

Last month, Trichet dusted off the phrase “strong vigilance”, which in the past signalled a rate rise was only a month away.

If, at Thursday’s news conference, he omits a reference to rates being “appropriate” and says the ECB is monitoring inflation “very closely”, markets will expect another rise in the coming months. But economists expect him to be coy.

The ECB may soften the impact of its key refi rate hike by leaving a subsidiary rate unchanged - a move that will be closely watched to gauge just how nervous the bank is about inflation and how much pain it thinks the periphery can bear.

The ECB’s overnight deposit rate, which acts as a floor for short-term market rates, could be exempted from the hike and left at 0.25%. This would make the refi rate rise largely symbolic; actual money market rates which guide the cost of bank borrowing might barely move.

An important issue that Trichet may have to dodge is when the ECB will phase out its offers of unlimited loans. These were introduced as an emergency step but have now become a liability, injecting so much money into banks that the ECB cannot effectively control market rates.

Last month, euro zone official sources told Reuters the ECB was close to creating a new liquidity facility that would support weak banks in Ireland and elsewhere, helping it eventually to phase out unlimited loans.

However, disagreements within the governing council over how much aid the central bank should provide to countries have caused that plan to be suspended. In the absence of an alternative to unlimited loans, Trichet will probably be unable to say anything explicit about ending them.